Social Security and Early Retirement

"Early retirement increases expenditures by increasing the number of retirees. It also reduces the tax revenues generated by people in the labor force. As a result, reforms that increase the early retirement age, or impose reductions in retirement benefits for those who retire earlier, could reduce overall program costs."

Although blaming the looming insolvency of developed country social security systems on aging populations is popular, critics often fail to recognize that many countries have benefit structures that add to cost by discouraging work. In those countries, people who work longer receive lower lifetime benefits. To avoid being penalized, they take early retirement. Early retirement increases expenditures by increasing the number of retirees. It also reduces the tax revenues generated by people in the labor force. As a result, reforms that increase the early retirement age, or impose reductions in retirement benefits for those who retire earlier, could reduce overall program costs in some cases by 20 to 50 percent.

In Social Security Programs and Retirement Around the World: Fiscal Implications Introduction and Summary (NBER Working Paper No. 11290), NBER Research Associates Jonathan Gruber and David Wise summarize the evidence underlying these conclusions. They report on the findings of a large group of economists from 12 different countries. The group used a common analytical structure to model how features of national Social Security systems affect retirement behavior. They then used these models to analyze the fiscal impact of several types of reforms, considering the effects on both benefits paid out and taxes collected from older workers.

The first reform considered is increasing by three years the age at which individuals become entitled to their Social Security benefits. Despite lengthening life spans and better health in old age, the proportion of men who are officially out of the labor force between ages 55 and 65 has increased substantially in the industrialized countries since 1960. It now ranges from 0.7 in Belgium to about 0.2 in Japan. Increasing the retirement age is a natural way to increase labor force participation, and to improve Social Security's fiscal position as well. Raising retirement ages in existing social security systems by three years would generate savings of over 40 percent in the United Kingdom, about 30 percent in the United States, and slightly over 15 percent in Italy.

The second reform that Gruber and Wise consider is making benefits "actuarially fair" with respect to early retirement, so that individuals who retire early get lower benefits and those that retire later get higher benefits. This is currently the approach taken by several nations, such as the United States, but it is not common in European nations. The modeling that underlies each nation's analysis shows that these financial incentives have very significant effects on the retirement decisions of workers. As a result, in those European nations moving to actuarially fair pensions, by increasing the amount of time people choose to work and pay taxes and decreasing the amount of time they collect benefits, the costs will be lower. Instituting actuarially fair pensions would reduce costs by about 40 percent in Germany and by 10 to 20 percent in Belgium, Denmark, Japan, the Netherlands, and Italy.

Finally, the teams of authors consider a "common reform" with an early retirement age of 60, a normal retirement age of 65, and actuarially fair benefits. The effect of the common reform illustrates how retirement age and benefits structure affect fiscal balance. In countries with relatively parsimonious pension systems or relatively high early retirement ages -- Canada, the United States, and the United Kingdom -- the common reform will raise costs by more than 40 percent. In countries with early retirement and benefit structures that penalize people who work longer -- Germany, France, Italy, Spain, and the Netherlands -- the common reform will generate savings of more than 40 percent of base costs.

--Linda Gorman
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